GESolutions 2009 - The Psychology of Financial Crises

GESolution 1

In building financial models to be used by policy-makers and investors, recognize the importance of emotions in financial decision making under uncertainty, including excitement and anxiety that lead to groupthink and changes in states of mind.

While the traditional economic paradigm of the ”rational agent“ has proved serviceable in many areas of economic activity the abstract and frequently volatile nature of financial assets greatly complicates interpretations of what is rational when it comes to actual human decision-making processes in more or less permanent conditions of uncertainty. The valuation of financial assets is inherently uncertain. Excitement and anxiety about loss tend to be ongoing, so that decisions influenced by groupthink and current states of mind may be the norm merely rising to extremes stimulating extensive herd behavior and emotions like fear and greed when investors are confronted either with asset price inflation or financial crisis.

Although it is widely recognized that neglecting these effects leads to strongly biased results, there is still a lack of models that integrate the findings from behavioral studies (or at least some major aspects of them) into existing generally accepted economic models in a mathematically tractable and practically applicable way.

Once established and generally accepted, such models would naturally be of great value to policy-makers. But they should also influence the behavior of investors, as they would have more substantiated support for their decisions even in turbulent times.

GESolution 2

Implement policies that impede the development of temporal myopia, divided states of mind, and groupthink. For example, tax short-term profit-taking at higher rates than long-term profit taking. Instead of capping the bonuses of financial executives, require that their remuneration schemes reflect the sustainable long-term performance of their firms.

It is well-known from neuropsychology that humans tend to place disproportionate importance on short-term gains over long-term ones and are strongly influenced by the context in which decisions are made. Research into investor behavior also shows that divided states of mind get created in which excited anticipation of rewards gets divided off from fear of loss. In economic decision-making, this can lead to huge biases. When a price bubble arises, fully rational traders can feel forced to invest in overvalued assets due to a combination of myopic incentive schemes that do not accept performance worse than the average even for a short time period and a fear of missing out.

A promising and direct approach to counteract such “temporal myopia” is to create impediments to make professionals think twice; for example to tax shortterm profits higher relative to long-term profits. At the company level, it is desirable to implement more sustainable incentive schemes, which reward longterm performance rather than focusing on short time periods and to examine ways to ensure directors of financial intermediaries are focused on a sustainable long-term future for their firms.

GESolution 3

Since there are often multiple stable equilibria in political and economic decisions, design financial-crisis policies that are sufficiently broad (covering enough policy instruments) and deep (involving policy changes of sufficient magnitude) to move the economy to a new, socially desirable equilibrium.

A possibility that is often ignored is the existence of several stable equilibria in a financial market. These equilibria usually will not be equally desirable, and which of them is realized may depend heavily on psychological effects.

In a financial crisis, one of the major tasks of government should be to restore the confidence of the investors to move the market from a less desirable equilibrium towards a more favorable one. As a concrete example, the government should have the goal of lifting credit flows to the level that would have prevailed without a crisis instead of just ensuring the solvency of systemically relevant agents.

GESolution 4

Develop a new information infrastructure on psychological biases in financial markets, including indices of potential overexcitement and the psychological effects of new financial instruments and of financial reporting systems. Make this information infrastructure available to the monetary and regulatory authorities.

To reduce fluctuations in financial markets, it is of great importance to provide reasonable data on the extent of asset-bubble potential (potential overexcitement) present in the markets. This might involve introducing indices that could be based on sentiment data (raised by questionnaires) as well as measures calculated indirectly from market data (for example, prices relative to fundamental data). Studies examining the likely psychological impact of financial innovations would also be useful.

As the public recognition and reliability of such indices is of crucial importance, they should be provided by independent authorities (for example, central banks), which also should have to take care for their public awareness.

Measures to promote transparency in financial markets more generally might contribute to greater stability, but they might also create instability. Transparency is broadly helpful to the behavior of institutions and markets, but with three caveats. First, too much transparency can exacerbate our myopic tendencies: for example, quarterly reporting and real-time benchmarking of traders’ relative performance. Second, not all information generated or published is intelligent. Third, there need to be systems that follow up and use information that is published.

GESolution 5

Include indices of psychological excitement in the design of monetary policy and of financial regulation.

Existing insights from behavioral economics and neuroeconomics are sufficient to justify financial regulators taking psychology into account in designing monetary policy and financial regulation. For example, monetary authorities should use indices of psychological excitement in an effort to identify asset price bubbles. This will help central banks mitigate such bubbles and thereby improve financial stability.

Regulatory rules need to reflect concerns about financial exuberance. For example, bank capital requirements should be designed to respond to variations in indices of excitement.

GESolution 6

Allow financial managers to be ranked in terms of long-term, but not short-term, performance.

Ranking of financial managers and advertising of mutual and other funds in a form that sets the financial market off in the pursuit of exceptionality encourages divided states of mind. Prevent the selection of some funds from the stable of funds that any financial manager has so as to advertise the highest performer.

Divided states of mind also arise when excitement about particular aspects of past performance are printed in big letters, followed by a disclaimer in small type about the link between past and future.